NEW YORK - A decade ago, investors snubbed dividends as a sign of companies incapable of growth, but since 2003, dividends have become a symbol of security and strength. And they're back in demand.
How long that will last, though, may depend on whether the 2003 tax laws that reduced the rate investors pay on these payouts are extended past 2008, when they are set to expire. If they are extended, the next question is whether Congress goes for a quick-short-term fix, as expected, or a long-term overhaul, according to experts.
"We've turned a corner," said Howard Silverblatt, a senior index strategist with Standard & Poor's of New York. Silverblatt was among four panelists to participate in a discussion on the resurgence of dividends and related public policy impact here last week, at a seminar organized and hosted by Boston-based Eaton Vance. "Investors are looking for total return," Silverblatt said.
Dividend-bearing shares offer just that. Although their value typically doesn't swell as quickly as their non-paying counterparts, when dividend-bearing shares drop, the decrease is not usually as steep, either. And then there is the guarantee of quarterly cash, which can be reinvested, used to buy other stocks or spent.
Companies like issuing dividends, because in an era of low interest rates and slow growth, it provides a tax-efficient way to clear excess cash from their ledgers, and acts as an added incentive to attract investors.
Dividends also owe much of their renaissance to the 2003 reforms to the tax code. Those changes dropped the dividend tax rate investors pay from 35% to 15%. Since then, the number of dividend-paying stocks and mutual fund offerings has increased. Last year, for example, 387 of the S&P 500 stocks paid dividends, compared to 351 in 2002, the year before the new law took effect.
Investors seek dividends for other reasons, too.
Those who can still hear the echoes from the burst technology bubble reverberating throughout Wall Street's concrete canyons learned that they can't always count on charge-ahead, bull market capital gains. Rather than go back down that road, they choose the less bumpy, albeit typically slower, path of dividend-bearing investments.
"Capital gains are hope at the end of the journey," Silverblatt said.
On the other hand, "dividends are a pay me now' mentality. Investors can take the dividend and reinvest it any way they like, or use it for current income," said Tom Roseen, a senior analyst with Lipper of New York.
That may be especially attractive to Baby Boomers facing fixed-income retirement and looking for cash, he said.
"We see a change in the way people think about the stock market, the way people think about taxes and the way people think about dividends," said Duncan W. Richardson, executive vice president and chief equity investment officer at Eaton Vance, and moderator of the panel discussion.
In the mid 1990s, close to 90% of companies in the S&P 500 index issued dividends. But then, investors began to favor technology start-ups with frenetic capital gains growth, but no dividends, instead. By 2000, fewer than 75% of the S&P 500 stocks paid investors dividends. Likewise, in 2000, open-ended equity mutual funds delivered investors $244.7 billion in long-term capital gains, but only about $32.5 billion in dividends.
That trend is shifting. In an Eaton Vance survey of more than 400 American investors that it released in January, 57% said they prefer regular, quarterly dividends to stock buybacks, a common practice of the 1990s, or one-time or irregular special dividends. Seventy-eight percent of those polled said that they consider dividends a sign of a company's financial health. "Compared to the findings of earlier surveys, these results show a significant shift in investor preference from an emphasis on growth investing toward a more value-oriented, conservative investment style," Richardson said.
Companies and mutual fund complexes alike have responded. In 2005, 78% of the companies in the S&P 500 Index and 32% of all U.S. publicly held companies paid dividends, according to Silverblatt. In 2000, less than 33% of technology companies paid dividends. Now the technology sector is issuing dividends faster than any other, he said.
Likewise, in 2005, mutual fund investors saw $66.5 billion in dividend payouts, compared to $124.8 billion in long-term capital gains, according to Lipper data.
Another Eaton Vance survey released in January showed that of 217 finance executives at publicly held companies, 47% believed dividend growth would continue to outpace earnings in 2006, compared to 24% who disagreed and 29% who were unsure.
In other cases, non-index fund companies are paying "extra cash issues."
"It's the forerunner to the dividend," Silverblatt said. These companies may be considering announcing regular dividends, or simply trying to keep investors from selling in favor of buying into dividend-paying competitors.
Dividends show corporate strength, but setting the precedent and then stopping dividend payments sends the opposite signal, Richardson said. Investors typically punish companies that cut or end dividends with a mass exodus, he noted. "It's a high bar to set," he added.
The trend toward more dividends may end if tax laws are not renewed or revised, according to panelists. Slashing the tax on dividends has resulted in significant savings for mutual fund investors and has significantly increased their appeal.
In fact, in 2002, mutual fund investors paid $2.6 billion in taxes on dividends. In 2005, taxes on dividends cost taxpayers $3.4 billion, an increase of 30.8%, despite a 138% increase in distribution value. Without the cuts, the taxes on 2005 dividends would have been $7.8 billion.
"We've all been talking about expenses in the market," Roseen said. But at as much as 2.6% of earnings, expenses pale in comparison to taxes, he said.
Citing slow-moving negotiations, Senate Majority Leader Bill Frist (R-Tenn.) last Wednesday vowed to make addressing the tax law a legislative priority.
While the best-case scenario would be a long-term fix, panelists agreed that what they expect is a one-year extension.
"It's Washington, it's politics, it's an election year," said Mark A. Weinberger, former U.S. Assistant Secretary of Treasury for Tax Policy under President George W. Bush and now vice chairman overseeing the Americas tax practice for Ernst & Young in Washington. "The debate about dividend and capital gains is not about tax, it's about procedure and politics," he said.
And uncertainty typically makes investors skittish. "If it is not extended, I see a sell-off in the market," Roseen said.
Seventy-seven percent of investors interviewed by Eaton Vance agreed that extending the tax cuts is critical, while 55% believe that failing to do so would hurt the economy.
Weinberger said that the threat of the law expiring is probably paralyzing some investors already when deciding on certain long-term investments. "When deciding in 2006 to invest in a company," he said, "future tax rates matter to investors now," he said.
Not so fast, said Alice Rivlin, a visiting professor at the Public Policy Institute at Georgetown University and senior fellow of economic studies at the Brookings Institution.
"Extending the reduced rates might do more harm than good," she said. "While applauding the lower rates on dividends, please don't forget they are a source of revenue. We need them for government services."
This poses a critical conflict for Baby Boomers, who are both turning to dividends to supplement retirement income and counting on Federal programs like Social Security and Medicare.
"People plan around tax policy, and we ought to let them," Rivlin said.
But that would mean a complete overhaul of the tax code, which currently double taxes dividends - first at the corporate level and then the individual investor. Unlike capital gains taxes, investors cannot soften the tax blow by using dividend payments to offset losses in a down year, either. Rivlin and Weinberger agree that such a comprehensive re-write is still years away.
"Never has it been more important to look outside of the U.S.," Weinberger said. In other countries, the tax code is more forgiving, he noted. Governments either credit corporations that issue dividends, don't tax dividends or have lower overall tax rates, he said, all of which put the U.S. at a competitive disadvantage.
Whatever comes out of the Capitol this legislative season, he said, "will be a battle of money and political trade-offs. [The tax agreement reached] won't be permanent, and it may not even be two years," Weinberger predicted.
That may cool the recent hot streak of dividend-seeking investors, Roseen said.
Richardson disagreed, arguing that the rise of the dividend represents a return to the principles blurred by the go-go capital gains-seekers of the past 20 years. "Investors appreciate a dividend-paying company," he said.
He should know. Eaton Vance has consistently issued dividends to shareholders since 1959. Not only do dividends represent a company that is financially sound, Richardson maintained, but also one that is accountable to its investors and more transparent over the long term.
"It's not just a good thing for investors, but a good thing for corporate governance," he said.
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